Investing in penny stocks is not generally recommended to serious investors, says Nirav Karkera of Fisdom

From choosing between growth and value stocks to going for direct investing and mutual funds, a new investor may have many basic questions that may perplex him/her. In an interview with MintGenie, Nirav Karkera, Head of Research, Fisdom addresses six key questions on investing.

Edited excerpts:

How to make the right choice between growth and value investing?

The right choices are often the ones in between the choices offered. The same applies to the subject of choosing between growth and value stocks, that is presuming one is able to correctly identify growth stocks and value opportunities. 

Growth stocks are the stocks of companies typically sensitive to rapid advancements or prospects of the same in specific industries. 

The performance of such stocks is largely attributable to rapid growth in earnings and future prospects robust enough to support the sustenance of such fast-paced growth. 

Considering active participation in accessible opportunities, such companies typically decide against dividend payouts and redirect cash flow towards capturing such opportunities. 

However, such bets are also characteristically vulnerable to economic and business cycles which makes the journey a rather choppy one. One such example could be the adversity being witnessed by several growth stocks on account of the global risk-off environment. 

Value investing, on the other hand, focuses on investing in mature, established yet discounted industry leaders. These companies are characterised by relatively less volatile and more sustainable earnings growth. 

Such companies often hit a rough patch which may have an impact on immediate earnings and the same reflects in their share prices. However, this rough patch may not suffice as an indicator of weakening future prospects. 

The value investing approach focuses on capturing such opportunities where strong companies with robust prospects are beaten down on a bad day. 

Growth investing and value investing must ideally be viewed as distinct strategies and not as two sides of a coin indicating mutual exclusiveness. 

While growth stocks look great on a good day, value stocks will look good on a bad day. While the choice largely depends on one's personality and objectives as an investor. 

For instance, a more aggressive investor who can stomach heightened volatility in the gambit of a farther yet lucrative payoff may accumulate more growth stocks while an investor seeking to build longer-term wealth with a relatively higher degree of predictability and possibilities of cash flows in the form of dividends, buybacks and similar corporate actions may steer towards value stocks. 

An active investor with the knowledge and time to manage the portfolio may want to position exposures to growth and value stocks basis macroeconomic and industry developments with requisite rebalancing. 

However, one with limited time, information or both may do well with their long-term portfolio if they continue to build a portfolio of companies which they would consider as having strong fundamentals, robust growth prospects and at least somewhere around their idea of a fair valuation while leaving the growth-value mix to simply be an outcome or derivative of the investment decision.

How do you find out if you are fit for direct investment in stocks or mutual funds?

Checking fitment for being a direct stock investor or mutual fund investor is rather straightforward. The primary condition for being an effective investor is investing only in what you understand very well. 

If one is able to track and synthesise the business and financial developments of a company while being able to form a reasonably strong investment rationale, such a person should start allocating to equity shares of the company while committing to continuous learning. 

Such a decision presumes that the investor does have the requisite time, access to necessary information, and knowledge to interpret and the ability to implement effectively along with the appetite for downsides that may tag along with the absence of any of these. 

On the other hand, an investor lacking or choosing to not access any of the above requisites may do better by outsourcing the job to a highly credible and reliable mutual fund manager. 

Outsourcing the job to a mutual fund manager simply means investing in highly promising mutual funds where highly qualified and responsible professionals are committed to the heavy-duty exercise of delivering performance through equities.

How to invest in foreign stocks? How can investors find out if it is really meant for them?

Like with every investment decision, the decision to invest in foreign stocks must also be made basis the end objective. 

Broadly speaking, the case for investing in foreign stocks is strong for three use cases. 

First, the investment opportunity holds promise to offer a lucrative payoff versus alternates available globally - including the domestic markets. 

Next, the investment is a hedge against another holding in the portfolio. Finally, the foreign stock should potentially insulate against foreign inflation and currency risks till one reaches the point of liquidating the asset to spend in foreign currency. 

In the case of foreign investment, that serves any of these objectives, there is merit in moving to act in line. However, the next roadblock specific to foreign stocks is access to information and context. 

Just like with cricket, even in investments, the home ground offers a certain analytical advantage in terms of known information including information on the pitch, environment and context. 

While approaching investments in foreign stocks it may be difficult to gain a fuller understanding of the security's context - including softer contexts of sentiments, governance, regulatory hurdles or any of the multiple other vectors that are not essentially captured by news or a formal database. 

Also, it could be difficult to figure out the correct sources for information or understand the information received in light of the application environment and laws. 

In such a situation, if accessible, it is ideal to seek assistance from a professional equity advisor who has a high degree of credibility in terms of analysing the specific stock you are seeking to invest in. 

If the objective is a broader one like gaining exposure to a specific economy or hedging against another, there are several Indian mutual funds offering access to either a curated set of stocks through a foreign fund or directly to a foreign market's index - both via international funds. 

The standard risks that one must be especially cognizant of while investing in foreign stocks are the risk of currency rate fluctuations and higher cumulative expenses among several other conceptual risks.

When we talk about diversification in stocks, how much is too much?

The subject of diversification is often viewed with a quantitative lens while ignoring the qualitative aspects of the concept. There are various statistical theories that suggest a variety of numbers to be the ideal count of securities in a well-diversified portfolio, with thirty being among the most popular ones. 

However, considering fast-evolving markets and industries like we observe today along with the unique nature of every portfolio objective, many such numbers are best deemed arbitrary for the common investor's perception. In line with a portfolio objective, one must decide on an ideal allocation strategy. 

This allocation strategy can be defined across an array of dimensions like sectors, size, quantitative metrics or even technical metrics. Contrary to the popular opinion believing diversification to be a subject matter of count, it is rather a subject matter of optimisation. 

A well-diversified portfolio is a key tenet of an optimal portfolio that focuses on the equilibrium where there is the least possible correlation between securities while the allocation to correlated securities is high enough to capture the maximum upside targeted through the securities. 

A great starting point for investors would be to invest in as less stocks as possible that align with the theme they are trying to capitalise upon while buying incremental stocks aligning with a non-correlated theme. 

Depending on risk appetite and conviction on the themes, it would help to hedge the exposures by investing in a certain percentage in a set of negatively correlated securities.

When should one choose passive investing?

Passive investing refers to investing in a tightly-defined investment basket where the constituents may change but in a predictable fashion as it aligns with the defined set of rules. 

For perspective, the most popular form of such a basket is indices. Passive investing is not the antithesis of active investing but rather a contemporary. 

Passive investing, as a style, is highly suitable whose investment strategy aligns well with the defined set of rules governing the investment basket like an index or an exchange-traded fund. 

An additional benefit would be that the expenses charged to such products are typically very low given the absence of active administration and management. 

While a lower expense is an important feature, it must not be considered in isolation to arrive at an investment decision since what really matters is the performance net of expenses which is guaranteed by a lower expense alone.

Should one invest in penny stocks? Are they worth taking the risk?

While there is no dearth of literature or multimedia glorifying the multibagger opportunities that many penny stocks have offered, there is limited coverage on the ones that did not survive the test of time. 

Challenges associated with penny stocks emanate from the fact that these are very small companies with negligible analyst coverage, very limited information on the public domain and often inaccessible insights from the management. 

Along with these fundamental challenges, the stock specifically is vulnerable to challenges pertaining to the security of such characteristics as the vulnerability to risks of illiquidity, impact cost and typical challenges associated with slim volumes. 

Unless there is a really strong reason, investing in penny stocks is not generally recommended to serious, long-term investors. With the larger universe conveniently offering to mitigate such basic stock-specific risks along with opportunities with an efficient, commensurate risk-reward payoff, taking on the risks associated with penny stocks seems unnecessary with an elevated probability of being capital destructive.

Disclaimer: The views and recommendations made above are those of the analyst and not of MintGenie.